How Much Is Sweat Equity Worth?

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HBR’s fictionalized case studies present dilemmas faced by leaders in real companies and offer solutions from experts. This one is based on the HBS Case Study “VeeV on the Rocks?” (product no. 410006-PDF-ENG), by Joshua D. Margolis, Christopher Marquis, and Laura Winig. It is available at hbr.org.

“Sorry, guys. Just a few more questions. I know this is boring.”

“Next time we’ll have to bring the vodka,” Brooks joked. “Anyone who spends so much time on our taxes should at least get to taste the product.”

“Actually, I’m hoping this will be our last meeting, since the filing deadline is next week,” said Laura, the accountant. “But the flavors do sound good. OK, so what’s the equity split between you two?”

Brooks was silent. Laura looked up.

“Even,” Tyler said. “Right, Brooks?”

“I hadn’t really thought about that,” Brooks said cautiously. He had, of course. He just hadn’t discussed it with Tyler.

“What’s the issue? We’re equal partners. We’ve been running this together from the start.”

“Well, not exactly the start,” Brooks said.

After all, Brooks was the one who’d spent five years working on beverage deals in the investment banking division at Morgan Stanley and had recognized the growth opportunities in the premium liquor market. He was the one who’d taken a year off to tend bar here in Los Angeles and test ideas. He was the one who’d decided on a line of sustainably produced herb-infused vodkas—Erbe. And he was the one who had put up all his savings—$250,000—to get started.

Yes, of course, Tyler had been there from the beginning to bounce ideas around with. That’s what the two cousins had always done growing up. Yes, Tyler had quit a pretty sweet private equity job to help Brooks only a month into the new venture, and had then persuaded their uncle Charlie to invest. And yes, he’d worked his ass off ever since. But was that worth a half stake in the company? Brooks wasn’t sure.

“Well, it was damn close to the start,” Tyler said, looking ticked off. Quickly, though, he collected himself. “Look, this isn’t something we should bother Laura with.” He turned to the accountant and mustered his trademark grin. “Laura, let the two of us talk and get back to you.”

“No problem,” she said. “We can finish the rest later.”

“What the hell was that?” Tyler practically shouted as soon as they’d left her office.

“Sorry, man,” Brooks said. “We should have talked about it before. Obviously, I know you deserve a bigger stake than you have on paper now.”

“Yes, bigger than nothing would be good.”

“But the investors already have 10% plus the upside we’ve promised them, and I don’t know that I’m ready to cut my stake to 45%.”

“So you don’t think helping you write the business plan, bringing Uncle Charlie on board, finding the perfect sustainable distillery, fixing the formula, and coming up with our entire branding and marketing strategy is worth 45%?”

“I don’t know what it’s worth. I’ve never done this before.”

“Was I supposed to negotiate it with you up front? With my cousin? This is ridiculous.”

“Look, I’m not trying to take anything away from you. I know you’ve earned a big piece of this company. Just let me think about what’s fair.”

“I know what’s fair. I can’t believe you don’t.”

They were stopped on the sidewalk, so Brooks tried to change the subject. “You heading back to the office?”

“No, I’m going to Malibu. I have to make sure everything is all set for the party tonight.”

“OK, I’ll see you there. I have another meeting with the lawyers about the TTB.” Brooks had spent six months getting approval from the Alcohol and Tobacco Tax and Trade Bureau to produce and sell Erbe, but he was still negotiating over what could be included on the company’s website. The entire process had been a bureaucratic nightmare. “And look,” he added, “don’t be angry about this. We’ll sort it out.”

“We’d better. If I’m working for less than half this company, I should stop working so hard.”

“He’s a Natural”

The party that night was packed. Mercedes was launching its new hybrid model, and Erbe was the exclusive liquor sponsor. It was a perfect “green luxury” pairing, as Tyler had promised. Brooks had to hand it to the guy. The cocktails—a basil gimlet and a thyme lemonade, both served on the rocks with fresh herb accents—were delicious; the crowd was hip; and Erbe bottles were prominently displayed.

“I like the lemonade better than the gimlet,” said Erica, Brooks’s girlfriend. She was a studio publicist and always had an opinion.

Brooks surveyed the room and saw Michael, a former SKYY executive who had agreed to serve as a consultant to Erbe, heading his way.

“Brooks, good to see you,” Michael said. “Just had a great conversation with Renee, one of Mercedes’s PRs in New York. She loves what we’ve done here. Loves it. Wants us to do Miami, too. And she’s got other clients right in our wheelhouse: Loro Piana, Element Hotels, Stella McCartney. I thought this would be an uphill climb with all the new flavored vodkas on the market—it’s getting pretty saturated—but the green-and-premium angle is giving us an edge, buddy, a real edge.”

Brooks hadn’t been thinking about marketing when he’d insisted on using an environment-friendly distillery and getting a carbon-neutral certification for Erbe. He actually believed in promoting sustainable industry practices. But being able to align the company with other high-end, socially conscious luxury brands—and their customers—was a nice benefit.

“I know,” Erica chimed in. “He’s made it eco without being eco. It’s very Stella.”

“He can certainly throw a party,” Brooks said, thinking of the ridiculously detailed TTB forms and investor financing agreements he’d been working on at the office all day.

“And the discoloration thing?” Michael asked.

A few months back, Brooks had gotten a series of annoyed calls from the managers of the L.A. clubs and restaurants where they’d first introduced Erbe. The vodka in those original bottles had started to develop a very faint yellow tint. The taste was the same, but obviously that didn’t matter; people like their vodka clear. So Brooks had immediately dispatched Tyler to hand-deliver replacement bottles and apologize to the customers. Then he’d called Bruno, his distiller in Nevada. They’d initially gone through nearly 200 formulas before settling on the right three for their basil, thyme, and rosemary flavors. But Bruno hadn’t been able to explain the discoloration—even after a week of investigation.

Finally, Tyler had suggested they call in a consultant, and he’d flown to the distillery with her. Within 24 hours they’d identified a stabilizing agent as the culprit and replaced it with another one. The first production run of the new formula was now 75 days old, about when the previous run had started to turn yellow. So far, every bottle was still perfect.

“Looks like it’s sorted,” Brooks said.

“Great—then I think we can start planning the national rollout,” Michael said. “And possibly international by this time next year. Where is Tyler, by the way? I want him to meet Renee.”

“He’s over there,” Erica said, pointing to a bar across the room. Tyler was behind it, his jacket off, juicing limes. “Is he bartending?”

“Seems so,” Michael said. “That woman he’s talking to? That’s Renee.”

“Honestly,” Erica said, smiling up at Brooks, “the kid’s a natural.”

He did his best to smile back.

“It’s Your Decision”

Brooks had just come into the office when his iPhone rang.

“Uncle Charlie,” he said.

“Brooks. Did I catch you at home?”

“No. I was up at five for a surf, but the waves weren’t great, so I’m at my desk.”

“I always did my best work before seven. Are you alone?”

“Yes.”

“How did the Mercedes thing go?”

“Really well.”

“Good. Tyler called yesterday and seemed confident about it.”

“He always does.”

“He also asked me for some advice.”

Brooks took a deep breath. “About what—women?”

Charlie chuckled. “About equity.”

“Was he asking his uncle or his investor?” Brooks said, his voice rising. “Because if it was the latter, he’s totally out of line.”

“That’s what I told him. But then I also told him a story I think you should hear, too.”

Charlie had a lot of stories. He was the youngest of five brothers—Brooks’s dad was the oldest, Tyler’s the middle—and the only one who hadn’t become a doctor. Instead Charlie had left L.A. for Hong Kong at 18, worked a series of odd jobs around Asia, and eventually founded what was now an extremely successful export business. Everyone in the family was well educated, well traveled, and well-off, but Charlie was a jet-setting multimillionaire entrepreneur. Brooks and Tyler had spent their entire childhood idolizing him.

“You were brilliant to structure your financing the way you did. I want you to stay smart—about money, about people. Think it all through.”

“Have you heard of Jordache jeans?”

“Sure—the Heidi Klum ads, right?”

“You should’ve seen their ads in the late ’70s and early ’80s. Anyway, I read an interesting article about their history in Bloomberg Businessweek recently. The company was founded by three brothers. They started out with a store that sold other denim brands, but only one brother had the money to get it off the ground. He wanted majority control of the company. After all, he was the one taking all the risk.”

“Right,” Brooks said.

“But his mother smacked him upside the head and told him to share with his brothers, and he did.”

“So you’re saying I should give Tyler half of Erbe because he’s family?”

“No—that guy was crazy to just bow down to his mother. What he should have done is thought seriously about not just the money but the ideas—”

“Erbe was my idea.”

“—and the work everyone had put in to get the company started and to turn it into the very different manufacturing business that it became. An idea’s just an idea until people turn it into something more.”

“So you are on Tyler’s side.”

“No, I’m on your side. This is your company, so it’s your decision. You were brilliant to structure your financing the way you did. We investors are guaranteed a tidy return if the company does well, but we don’t own you. If you eventually sell out to Diageo for $100 million, that’s mostly yours.”

“That was smart,” Charlie continued. “I want you to stay smart—about money, about people, about financing, about retention. Think it all through. Think it backward. Think it forward.”

“You know I love Tyler,” Brooks said. “And of course I needed him, or someone like him, to get Erbe started. And of course I know he has great relationships with the investors and the customers. But I can’t help thinking that the idea, and the investment, and all the hard work I’ve put in—not schmoozing but dealing with the distiller and the regulators and the environmental certification board and the lawyers and the banks—entitles me to keep control.”

Brooks’s desk phone started to ring, so he quickly thanked Charlie and said good-bye. When he picked up the receiver, it was Bruno. “Brooks, we have a problem. We see yellow in some of the test bottles. I mean, it’s only the slightest wisp, but it’s there. The consultant thought she fixed it, but she didn’t.”

Before Brooks could respond, his call waiting beeped. Who else was calling him this early?

“Hold on, Bruno,” he said, and then, “Hello?”

“Brooks? Oh, hi, sorry, I wasn’t expecting you to answer. I thought I’d get voice mail. Anyway, it’s me, Laura, from Baxter and Billings. It turns out that we need to get these filings in by the end of this week, and, um, well, obviously, a few items are still outstanding. So would you have time to talk that through today?”

“OK,” Brooks said wearily, “if it’s urgent. But there’s something I have to handle first. Can we do it late—say, at six or seven?”

“Great. I’ll call you at seven. And, um, would you like to include Tyler on the call or not? It’s obviously, um, unnecessary if you’re the majority owner.”

“Right. Then I think I should be able to give you all the answers you need.”

“OK.”

Brooks hung up and gazed at the light blinking for Bruno on hold. Did he have all the answers?

What Would You Do? Some advice from the HBR.org community

Brooks bred an idea, planned a path, and built a strategy. Tyler faithfully and brilliantly executed many of its angles. Together they make a great team. But Brooks clearly leads, and that should be reflected in the equity structure. To me, 46%/44% would be fair.Gerhard Gallardo,automotive executive, Lima, Peru

Easy and simple: Each gets 45% ownership, but Tyler owes the company $250,000, which he can pay back over time out of his profits. Their sweat equity, knowledge, and commitment are equal. The only thing that isn’t is the cash up front.Stafford Kendall,cofounder, Covalent Logic

Most people overestimate their own contributions and downplay those of others. These two need a neutral third party to lead them through a discussion and negotiation until everything has been said, heard, and acknowledged and they reach an agreement they can both live with.David Kaiser,executive coach and CEO, Dark Matter Consulting

Should Brooks give Tyler half his stake in Erbe?

The Experts Respond

Courtney Reum is the founder of VeeV Spirits.

In a completely rational world, Brooks wouldn’t cede half his stake in Erbe to Tyler. The company was his idea. He invested the money. But the world isn’t completely rational. Relationships and emotions matter, so Brooks should consider giving his cousin what he wants.

This case is loosely based on VeeV, which produces an açaÍ-infused liquor and ready-to-drink cocktail mixes. I started the company in 2007 and was joined a few months later by my younger brother, Carter. We never talked about money or equity in the beginning. We grew up together. We went to college together. We used to live together in New York. We’ve always shared without getting specific about it. So we just hit the ground running, as you do in a start-up business, trying to get everything done yesterday, dividing and conquering, plugging holes. One day you feel like the CEO; the next day you feel like a janitor.

Several months in, when the subject of ownership finally came up, I realized that we should have discussed it earlier. Carter wanted half my stake, and initially I didn’t want to give it to him. Don’t get me wrong: I knew he was an integral part of VeeV. He had worked incredibly hard and invested some of his own money. So I wasn’t thinking the split should be 80/20. But 60/40, as a nod to my having come up with the concept, taken the initial risk, and gotten the company started? That seemed fair.

I sought advice from others, including my father, a successful businessman. Everyone agreed that I should keep a bigger share of VeeV. But I knew this might become a major point of contention between Carter and me. I didn’t want to be selfish, especially not with my brother. I thought a dispute might disrupt not only our relationship and the growth of our company but also our entire family’s dynamic.

The more skin Tyler has in the game, the more motivated he’ll feel.

So I agreed to a 50/50 split of my stake. In return, I’m listed as VeeV’s managing member and have final sign-off on all decisions. Carter feels appreciated, respected, and well compensated, which is important to him. I feel I still have control over the business, which is most important to me.

It’s natural for Brooks to want to retain as much equity as he possibly can: In the liquor industry, even the most successful start-ups grow to be worth $50 million to $100 million—leaving a much smaller pie to divide than, say, a highly scalable technology company that’s quickly worth billions. That’s why VeeV, like Erbe, offered most of its investors a minimum guaranteed return on profits rather than shares in the company.

But Brooks should recognize that the more skin Tyler has in the game, the more motivated he’ll feel. That will also be true of any other executive Erbe brings on board. Carter and I a few years ago agreed to set aside an equal number of our VeeV shares so that we have some to offer C-suite and midlevel managers we want to incent with stock or options.

Today we have so much going on at VeeV that I rarely think about how our equity is divided. Revenue has been doubling year over year, and we are one of the top three fastest-growing spirits brands in the United States. Our vodka is in all 50 states, and we hope to launch internationally next spring. That success has depended on the strong partnership between my brother and me. And we’re still best friends.

Jon Olinto is a cofounder of b.good, a chain of high-quality fast-food restaurants.

Uncle Charlie gave Brooks some good advice. Entrepreneurs have to compensate the people who help them get started. Tyler’s contribution to Erbe so far is clear, and Brooks should therefore give him a significant chunk of equity. But as the person who conceived of the company and took all the financial risk, he shouldn’t sacrifice majority control. His stake should be at least 51%, and since the investors already have 10%, that means Tyler’s would be capped at 39%.

Whether the split is there or at 60/30 or at 70/20 is Brooks’s decision, but he should be generous enough that the personal relationship with his cousin is preserved and Tyler feels valued and excited to come to work each day. Going forward, discussions—with any executive or employee—about equity or other compensation, including options, bonuses, and salary, should be conducted up front and tied to quantifiable metrics.

Eight years ago, when my best friend, Anthony Ackil, and I started b.good, a restaurant chain devoted to making fast food more “real,” that’s how we proceeded. Although we came up with the idea and wrote the business plan together, we decided from the beginning to issue our stock on the basis of investment. We both put our life savings into opening the first restaurant, but because Anthony had more money than I did, he was able to buy more shares. Two other people who helped us plan our launch also invested in that founders’ round. That’s how we agreed to structure it, and we’ve never challenged the agreement.

Our focus has always been on creating a great business—not on who gets what. I think that’s true for most entrepreneurs. Like Brooks and Tyler, they’re excited about their ideas, so they don’t have those conversations. But you have to have them when you fund the company. When Brooks put up his $250,000, he should have told Tyler what he thought it meant. If Tyler thought that leaving his private equity job to work for Erbe was tantamount to an investment, he should have said so to Brooks.

Once this situation is resolved, I see a bright future for the partnership, as long as the cousins continue to embrace their complementary skill sets. My relationship with Anthony works that way. As b.good has grown to eight locations in Massachusetts and created franchise opportunities in other states, we’ve naturally divided our responsibilities. I focus on brand and marketing, like Tyler, while Anthony does finance and operations, like Brooks. We’re both passionate about the jobs we do, and each of us understands how hard the other works. I never think, “Why am I sweating at a community barbecue when Anthony’s preparing for a board meeting?” And he never thinks, “Why am I stuck at the office while Jon gets to serve burgers to kids?” We’ve known each other since childhood, so we trust each other completely. I think that’s the profile of a successful entrepreneurial partnership. The relationships that suffer over time are the ones in which the partners care about the same things and encroach on each other. Anthony and I also recognize when we should seek outside advice. Five years ago we set up a board of investors and industry experts to help us decide potentially contentious issues such as our own compensation packages. Brooks might consider doing the same at Erbe.

Since b.good’s launch, we’ve had five additional rounds of investment, in which neither Anthony nor I was able to participate. As a result, our stake has been significantly diluted. But we knew that would happen as b.good grew, because restaurants are so capital intensive. We never let our personal desire for ownership or money prevent us from doing what was best for the company. The dream is to create something that will someday have tremendous value. If Brooks and Tyler both believe in Erbe and work tirelessly to make it a success, it won’t matter whether the split is 45/45, 51/39, or 60/30, because there will be plenty of upside to go around. Everybody will win.

A version of this article appeared in the December 2012 issue of Harvard Business Review.